Progress on the Laffer Curve*

The title of this piece has an asterisk because, unfortunately, we’re not talking about progress on the Laffer Curve in the United States.

Instead, we’re discussing today how lawmakers in other nations are beginning to recognize that it’s absurdly inaccurate to predict the revenue impact of changes in tax rates without also trying to measure what happens to taxable income (if you want a short tutorial on the Laffer Curve, click here).

But I’m a firm believer that policies in other nations (for better or worse) are a very persuasive form of real-world evidence. Simply stated, if you’re trying to convince a politician that a certain policy is worth pursuing, you’ll have a much greater chance of success if you can point to tangible examples of how it has been successful.

And it’s why I’m quite encouraged that even the squishy Tory-Liberal coalition government in the United Kingdom has begun to acknowledge that the Laffer Curve should be part of the analysis when making major changes in taxation.

Chancellor of the Exchequer George Osborne has cut Britain’s corporate tax rate to 22% from 28% since taking office in 2010, with a further cut to 20% due in 2015. On paper, these tax cuts were predicted to “cost” Her Majesty’s Treasury some £7.8 billion a year when fully phased in. But Mr. Osborne asked his department to figure out how much additional revenue would be generated by the higher investment, wages and productivity made possible by leaving that money in private hands.

By the way, I can’t resist a bit of nit-picking at this point. The increases in investment, wages, and productivity all occur because the marginal corporate tax rate is reduced, not because more money is in private hands.

The Wall Street Journal obviously understands this and was simply trying to avoid wordiness, so this is a friendly amendment rather than a criticism.

Anyhow, back to the editorial. The WSJ notes that the lower corporate tax rate in the United Kingdom is expected to lose far less revenue than was predicted by static estimates.

The Treasury’s answer in a report this week is that extra growth and changed business behavior will likely recoup 45%-60% of that revenue. The report says that even that amount is almost certainly understated, since Treasury didn’t attempt to model the effects of the lower rate on increased foreign investment or other “spillover benefits.”

And maybe this more sensible approach eventually will spread to the United States.

…the results are especially notable because the U.K. Treasury gnomes are typically as bound by static-revenue accounting as are the American tax scorers at Congress’s Joint Tax Committee. While the British rate cut is sizable, the U.S. has even more room to climb down the Laffer Curve because the top corporate rate is 35%, plus what the states add—9.x% in benighted Illinois, for example. This means the revenue feedback effects from a rate cut would be even more substantial.

But the logic of the Laffer Curve also explains why we should lower personal tax rates. But it’s not just curmudgeonly libertarians who are making this argument.

Writing in London’s City AM, Allister Heath points out that even John Maynard Keynes very clearly recognized a Laffer Curve constraint on excessive taxation.

Supply-side economist?!?

Even Keynes himself accepted this. Like many other economists throughout the ages, he understood and agreed with the principles that underpinned what eventually came to be known as the Laffer curve: that above a certain rate, hiking taxes further can actually lead to a fall in income, and cutting tax rates can actually lead to increased revenues.Writing in 1933, Keynes said that under certain circumstances “taxation may be so high as to defeat its object… given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget. For to take the opposite view today is to resemble a manufacturer who, running at a loss, decides to raise his price, and when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, decides that prudence requires him to raise the price still more—and who, when at last his account is balanced with nought on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss.”

For what it’s worth, Keynes also thought that it would be a mistake to let government get too large, having written that “25 percent [of GDP] as the maximum tolerable proportion of taxation.”

But let’s stay on message and re-focus our attention on the Laffer Curve. Amazingly, it appears that even a few of our French friends are coming around on this issue.

Here are some passages from a report from the Paris-based Institute for Research in Economic and Fiscal Issues.

In an interview given to the newspaper Les Echos on November 18th, French Prime Minister Jean -Marc Ayrault finally understood that “the French tax system has become very complex, almost unreadable, and the French often do not understand its logic or are not convinced that what they are paying is fair and that this system is efficient.” …The Government was seriously disappointed when knowing that a shortfall of over 10 billion euros is expected in late 2013 according to calculations by the National Assembly. …In fact, we have probably reached a threshold where taxation no longer brings in enough money to the Government because taxes weigh too much on production and growth.

P.S. The strongest single piece of evidence for the Laffer Curve is what happened to tax collections from the rich in the 1980s. The top tax rate dropped from 70 percent to 28 percent, leading many statists to complain that the wealthy wouldn’t pay enough and that the government would be starved of revenue. To put it mildly, they were wildly wrong.

I cite that example, as well as other pieces of evidence, in this video.

P.P.S. And if you want to understand specifically why class-warfare tax policy is so likely to fail, this post explains why it’s a fool’s game to target upper-income taxpayers since they have considerable control over the timing, level, and composition of their income.

6 Responses

As mentioned in the PPPS, the Laffer curve is relevant, but largely a red herring in the grand scheme of things. When it comes to prosperity, the only curve that matters (in anything but the dominant short sighted naïve voter-lemming world) is the Rahn Curve, where the growth maximizing trendline point occurs even before the max of the Laffer curve. The only importance of the Laffer curve is thus its relevance to the Rahn curve. Revenue maximization is an arbitrary irrelevant point. Revenue maximization happens way past the top of the Rahn curve, the long term prosperity maximizing point.

When Keyes mentions: “Given sufficient time to gather the fruits”, he is basically making the case for the Rahn curve — intentionally I presume. I would actually add “given enough time to establish a crop mechanism where its producers have high stakes in the game and an immediate interest in its success” I.e. unadulterated effort-reward curves.

But it’s all water under the bridge.
More than anything, the Rahn curve embodies the voter lemming’s self destructive behavior:”a redistribution dollar in the bag today is worth five perpetually compounding growth dollars in the future”. In that phrase lies the unfolding of what one day historians will call “the mass economic suicide of western world voter-lemmings in the early 21st century”.

So, for the Nth time,

The divergence in prosperity caused by growth deficit is relentless. The submersion towards average worldwide prosperity ruthless.

Our western world growth rate lags average worldwide trendlines, our flattening of the effort-reward curves suppressing our competitiveness towards European levels. What do we do? We increase taxes!

Reminds me of the phrase “we’re loosing money on every transaction but we’ll make it up with higher volume”. But as long as reheated narratives for immediate redistribution keep popping up, voter-lemmings keep hoping. The decline continues…

While I agree with Zorba’s points, the Rahn Curve is an after the fact observation by country that one would think would lead toward reductions in the size of governments, but doesn’t, because most incentives for legislators derive from growth in government.

The Laffer Curve is an estimation of the revenue effect of tax rates on individual incentives. It is drawn based on the highest marginal rate, assuming that those paying the top rate have the most flexibility to adjust their behavior. However, a Laffer effect is operative on all taxes rate increases or decreases, based on individual actions and the income or income equivalent context for that individual.

One can also expand the scope of Laffer effects to those receiving means-tested benefits. The higher the marginal cost of losing benefits the greater the loss of revenues. While the tax revenues lost from any individual may be small, because of the large number of such individuals the net effect is enormous.

The Bush Administration dealt with the Laffer Curve by cutting back income tax rates on rich people, and even during the Obama Administration the Republicans in Congress have insisted that nobody roll back those cuts. If taxes are going to end up being raised, they want the middle class and poor to pick up most of the extra cost.

And it’s not like Laffer was some really brilliant economist when he made it up; he was a relatively young guy with good political connections saying something that the Reagan Republicans really really really wanted to hear. I saw him interviewed on TV a few years ago, wearing a bad toupee and sounding kind of apologetic about it.